Viewpoints on Financial Planning
Prior to 1965, roughly half of older adults were covered by private health insurance. To enhance coverage and ensure greater financial solvency for elderly Americans, Congress created Medicare under Title 18 of the Social Security Act. Medicare provides health insurance to people age 65 and older, regardless of income, pre-existing condition or past medical history.
Several decades later, Congress has expanded Medicare coverage to include more Americans who cannot otherwise get coverage from private insurers. Congress also added the state-managed, means-based Medicaid program to provide coverage to more uninsured and disabled persons 18 years of age or older.
Despite these strenuous and expensive efforts, the underinsured or uninsured gap continued to grow. Estimates of projected health care costs according to the Department of Health and Human Services will increase by more than $200 billion from 2010 to 2019.
In March 2010, Congress and the President proposed and passed the Patient Protection and Affordable Care Act (PPACA). Beginning in 2014, the PPACA requires individuals not covered by employer- or government-sponsored insurance plans to maintain minimal health insurance coverage or else pay a penalty, unless exempted (a.k.a. the “individual mandate”).
The Act also affects the private health insurance industry and public health insurance programs by requiring coverage for pre-existing health conditions and extending coverage to 30 million uninsured Americans. Some experts say the future price tag may be in the trillions of dollars. To prepare for that eventuality and pay the tab, Congress included several new Medicare taxes in the Act that took effect January 1, 2013. This article will explain the taxes and suggest financial planning options which may help one avoid and/or minimize these added taxes.
FREQUENTLY ASKED QUESTIONS
1. What are the new Medicare taxes?
The new 3.8% Medicare surtax will be assessed on the lesser of an individual’s “net investment income” or the amount that an individual’s “Modified Adjusted Gross Income” (MAGI) exceeds a “threshold amount” set by the government. This levy applies to joint filers with MAGI above $250,000 (married filing separately $125,000) and single filers with MAGI above $200,000. Second, Congress added a new payroll tax for higher income earners, which will be explained further in FAQ #6.
2. What is Modified Adjusted Gross Income (MAGI)?
As stated before, the government threshold amounts are based on MAGI. To explain, adjusted gross income (AGI) is the number at the bottom of the front page of IRS Form 1040. This figure includes wages, taxable interest, capital gains, unemployment compensation, tips, dividends, the taxable portion of Social Security, retirement plan distributions and any income which is derived from partnerships and other small businesses.
MAGI, on the other hand, is typically a larger number than AGI. Why? Well, MAGI is calculated by adding back certain items to one’s AGI, such as foreign income and foreign housing deductions.
3. What Is Net Investment Income?
“Net investment income” is before-tax income received from investment assets, such as bonds, stocks, mutual funds, loans and other investments minus related investment expenses. Typically, the applicable individual tax rate on this type of income depends on whether it is interest income, qualified dividend income or capital gains.
For the purposes of the 3.8% tax, investment income shall include the following: the taxable portion of annuity distributions, interest, capital gains, dividends, passive activity income, rental income and royalties.
Now for the good news. Investment income shall not include IRAs or other qualified retirement plans distributions, any of the income types listed in the preceding paragraph so long as it is derived from an active trade and/or business, and income subject to the self-employment tax. Also, any capital gain resulting from the sale of an active business interest in a partnership or S-corporation shall not be fully subjected to the surtax.
4. What is a “threshold amount”?
Right now, the new surtax does not apply to all income levels. Rather, Congress has set certain levels of income where the surtax becomes applicable. The threshold amounts are: $250,000 for married taxpayers filing a joint return, $125,000 for married taxpayers filing separate tax returns, $200,000 for all other individual taxpayers, and $11,650 for trusts and estates.
5. Who will be affected by the 3.8% Medicare surtax?
If an individual’s MAGI is equal to or less than the threshold amount, then the 3.8% surtax is not applied. However, if MAGI is greater than the threshold amount, then the 3.8% Medicare surtax is applied to the lesser of investment income or the excess of MAGI over the threshold amount.
- Jim and Tina, married filing jointly, have $500,000 of salaries and no other income. The surtax would not apply as they have no net investment income.
- Linda and Paul, married filing jointly, have $500,000 of salary income and $50,000 of net investment income. The surtax would apply only to the $50,000 of net investment income because the $50,000 of investment income is less than their excess of MAGI over the applicable threshold amount (i.e. $550,000 - $250,000 = $300,000 MAGI excess).
- Amy, a single filer, has $275,000 of net investment income and no other income. The surtax would apply to $75,000 of income because her MAGI was $75,000 over the $200,000 threshold amount.
- Henry and Anne, married filing jointly, have $225,000 of salaries and $125,000 of net investment income. Their MAGI is $350,000 and their threshold amount is $250,000. Therefore, the surtax would apply to $100,000 of income because the difference between their threshold amount and their MAGI is less than the amount of net investment income ($125,000).
- Errol and Olivia, age 77, have pension and qualified plan income of $550,000, $35,000 of tax-exempt income and no taxable investment income. The 3.8% surtax does not apply because they have no net investment income.
- In 2013, Humphrey and Lauren, age 69, had investment income of $250,000 and were not subject to the surtax. In 2015, however, they had $250,000 of investment income and were required to take IRA required minimum distributions (RMDs) totaling $150,000. Now their $400,000 MAGI exceeds their $250,000 threshold by $150,000. As a result, $150,000 of income is subject to the Medicare surtax. Although RMDs are not subject to the surtax, it did push their investment income up above the threshold thus subjecting it to the surtax.
6. What is the Medicare tax increase for high-income earners?
The Medicare portion of FICA has been a flat-tax on all wage earners, but since 2013, it has a progressive element. The Medicare tax has been increased by 0.9% (from 1.45% to 2.35%) on wages and self-employment income above $250,000 for joint filers, $200,000 for single filers or $125,000 for married filing separately. The Medicare tax is uncapped and is not deductible for self-employed taxpayers.
For example, a married couple earns a combined income of $300,000/yr ($150,000/yr each). Currently, each owes 1.45% of Medicare tax (or $2,175) and their respective employers owe a matching dollar amount. Starting in 2013, however, the couple will owe an additional 0.9% on $50,000, or $450, since their combined income exceeded their $250,000 threshold by $50,000. This additional tax is paid upon filing their return and will not be withheld by their employers.
7. How can I manage or reduce the impact of these new Medicare surtaxes?
- In 2014, seek to reduce MAGI by increasing workplace retirement plan and IRA contributions. Also, if available, participate in an employer’s non-qualified deferred compensation plan.
- A Roth IRA conversion that would not otherwise trigger the surtax in the current year could potentially save Medicare surtaxes during retirement years. Roth IRAs are not subject to the post-70½ required minimum distribution rules. Furthermore, tax-free Roth IRA distributions will not count toward MAGI. Lastly, by paying the Roth conversion taxes with non-qualified cash or investment accounts this year, it could result in lower future net investment income.
- Consider tax-exempt or tax-deferred investments that reduce one’s MAGI and income taxes (e.g., municipal bonds).
- Real estate investments can create valuable income-reducing depreciation deductions.
- Time the realization of capital gains to minimize the impact of the Medicare surtax. To reduce such taxes as well as income taxes due in the current year, one can realize capital losses in their portfolio to offset capital gains and up to $3,000 of other income.
- Installment sales can produce the type of income subject to the 3.8% Medicare surtax. However, installment sales can also help even out income over a number of years and thereby potentially stay under the MAGI threshold amounts.
- Finally, charitable trusts can defer the recognition of income over a number of years (again, to stay under the MAGI threshold).
Charitable remainder trusts (CRTs), for example, may provide a way to liquidate securities free of immediate capital gain taxes, obtain an income tax deduction and delay the recognition of income over a period of time. CRTs allow a charitably inclined individual to contribute appreciated assets to the trust, sell the assets within the trust without immediate taxation, and, in return, receive an income stream from the trust for a set period of time. At the end of the CRT term, the balance of the trust assets pass to a single charity, or multiple charities, of one’s choosing.
Effective January 1, 2013, the top federal and Medicare tax rate on long-term capital gains for high earners jumped from the historic low of 15% in 2012 to 23.8%. Furthermore, the top federal rate on qualified dividends roughly tripled from 15% to 43.4%.
Equally significant, the top federal income tax rate on ordinary income went from 35% to 39.6%. With the added Medicare surtaxes on net investment income and compensation, the top federal rate can be as high as 44.3% (39.6% + 3.8% + 0.9%) and would be in addition to state and local taxes, if any. These numbers do not include the impact of the loss of itemized deductions and personal exemptions when a taxpayer’s adjusted gross income exceeds the applicable thresholds for phasing out these deductions and exemptions.Strategizing to minimize the impact of income and the new Medicare surtax is a multi-year process and is not always painless. Certainly, any of these suggestions should be carefully reviewed with one’s local tax counsel.